Few academics have influenced modern portfolio management more than Eugene F. Fama and Kenneth R. French. Their 1992 paper, "The Cross-Section of Expected Stock Returns" (Journal of Finance, June 1992), turned the Capital Assets Pricing Model (CAPM) on its head and laid out a new explanation for the real source of stock returns.
The paper found that U.S. (and later international) stock returns could be explained by a portfolio's exposure to three factors:
- The market (i.e., beta)
- Size (small caps outperform large caps)
- Value (value stocks outperform growth).
Over time, this "three-factor model" has proven remarkably accurate, and has spawned a generation of investors (and a massively successful asset management firm, Dimensional Fund Advisors) that tilts indexed portfolios towards small and value. And even though traditional, "broad-based" indexers hate to admit it, those small/value investors have done pretty well over the past decade.
Journal of Indexes senior editor Matt Hougan spoke with Fama and French recently about the state of the market, the rise of "fundamentally weighted indexes" and why investors continue to throw money away on active management.
[Fundamentally weighted indexes] are a triumph of marketing, and not of new ideas.
-Eugene F. Fama
Journal of Indexes (JoI): The market has been through some wild rides since you wrote your seminal paper in 1992. Has anything altered the views you have vis-à-vis the sources of return in the market?
Kenneth French (French): I don't think so…
Eugene Fama (Fama): No, I don't think so.
French: Actually, I take that back. Initially, we thought the value premium was associated with distress risk. I'm not so confident of that any longer.
What's clear is that the value effect is a catchall for differences in expected return. Without pernicious assumptions about expected growth, any differences in expected return will show up in ratios like book-to-market, earnings-to-price, or cash flow-to-price. Take a company with a high expected return. When you discount its expected future cash flows back to the present, the high expected return (which is also the discount rate) gives you a low price relative to the expected cash flows. As long as the fundamental metric—the book value, earnings, etc.—is a reasonable proxy for the expected cash flows, you'll also get a low price relative to the current fundamental. This simple discount rate effect implies that differences in expected return are almost certainly linked to ratios like book-to-market.
Notice that I didn't say why there are differences in expected return; I just said that if there are differences in expected returns, they will show up in ratios like book-to-market. That means the value effect is a catch-all that captures any differences in expected return-whatever their source.
I think the differences in expected return are the result of an amalgamation of different risks, plus some mis-pricing. And I don't think we have the technology to distinguish between those two.
Fama: I don't know about the mispricing. I don't know that there is mispricing.
French: There has to be some mispricing. I'm certainly not saying it's all mispricing. I like to tell people that it's 87.38 percent risk.
Fama: I don't know about the mispricing part. I think he's wrong there.
French: To get back to distressed companies … the typical high book-to-market company is distressed. But if you hold book-to-market fixed and you sort companies by financial distress, you don't get much difference in average returns. So something else is at work.
JoI: A raft of new academic, quasi-academic and "fundamentally weighted" indexes have come to the market in the last few years. What are your thoughts on these products? How do they fit or not fit with your research?
French: The academics have been well aware of these issues for 15 years. It's just value vs. growth. It's nothing more than that. The argument that they've invented the notion that these measures capture mispricing is ludicrous. It's been in the academic literature for a long time.
Fama: And there are lots of active money management companies with products that claim to implement these ideas.